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CONFIDENCE IN THE WENDY'S/ARBY'S GROUP has been shrinking like an overcooked hamburger on a sizzling grill. Declining sales at Arby's, plus the company's reluctance to specify how it will use most of the proceeds from a recent $565 million bond offering, worry investors. Since late April,
Wendy's/Arby'swen -2.154398563734291%Wendy's Co.U.S.: NasdaqUSD10.9
-0.24-2.154398563734291%
/Date(1427835600259-0500)/
Volume (Delayed 15m)
:
4234745AFTER HOURSUSD10.9
%
Volume (Delayed 15m)
:
1666484
P/E Ratio
34.0625Market Cap
4095375942.86545
Dividend Yield
2.018348623853211% Rev. per Employee
66059.7More quote details and news »weninYour ValueYour ChangeShort position
stock (ticker: WEN) has slid more than 30%, to around $3.70.

But investor Nelson Peltz, who with his partner Peter May owns 22% of the shares, argues that "this is a phenomenal company that is truly misunderstood and was mismanaged for years.... We think the company is significantly undervalued." His assessment isn't based on earnings -- operating net is likely to be just 19 cents a share this year and 28 cents in 2010.

If investors put a multiple of nine on 2011 Ebitda, as Peltz suggests is reasonable, the company would be valued at $5 billion. After subtracting $1 billion of net debt and dividing by 470 million shares outstanding, the stock theoretically would be worth $8.50. That is a big if. But even a multiple of seven would translate into a $6 stock.

While Peltz's multiple assumption might be aggressive, his operational expectations aren't. They don't include any benefit from putting the company's substantial cash to work or from new products, better marketing or the reintroduction of breakfast slated for late next year.

Peltz and May, both Wendy's/Arby's directors, doubled down on their bet late last year, spending $205 million for 49.4 million shares at $4.15.

This didn't escape the attention of some value investors, including Robert Gebhart, a partner at New York City-based money manager Grisanti Brown & Partners, which owns shares. He contends that, if the stars align, shares could reach $9 in three years.

AP Photo/Terry Gilliam; REUTERS/Jason Cohn (inset)

Wendy's/Arby's was formed last September, when Arby's, then owned by Triarc, an investment company controlled by Peltz and May, merged with Wendy's. When announced, the all-stock deal was valued at $2.86 billion. Wendy's shareholders received 4.25 Triarc shares.

Wendy's was founded 40 years ago in Columbus, Ohio, by Dave Thomas, a food-industry veteran who tried to separate it from the pack by offering better food. Its hamburger patties aren't frozen, and it offered salads before they became a staple at rivals. Wendy's has floundered since Thomas, who had become its public face, died in 2002. Trian, an investment firm run by Peltz and May, bought a 5.5% stake in Wendy's in 2005, when the shares traded mostly in the mid-teens.

Arby's is smaller than Wendy's -- kicking in only about a third of Wendy's/Arby's $3.7 billion of 2008 sales and about 35% of its operating income. Its specialty: roast-beef sandwiches. Last year, Wendy's/Arby's posted a loss of $3.05 a share, in large part on costs related to the merger.

Wendy's/Arby's Chief Executive Roland Smith aims to improve results at the company with $60 million in cost efficiencies and $100 million from boosting the 12% operating margins at Wendy's company-owned stores, which vastly trail franchise stores' 17%. (About 20% of Wendy's are company-operated.) For its part, Arby's should benefit from new products; it's even considering a catering and delivery service for large orders.

Smith hired David Karam as Wendy's president last year. Karam also had bid for Wendy's and was among the larger and more successful franchisees. Pamela Thomas Farber -- daughter of Wendy's founder and the owner of 33 Wendy's in Ohio -- says that she has known Karam all her life, and that now, for the first time since her father died, she has had confidence in corporate management.

The $565 million bond offering, however, is a bone of contention. Out of the proceeds, Wendy's/Arby's will use $132.5 million to repay some of its bank debt. As for the remainder, it has said only that the money will be used for general corporate purposes, meaning anything from working capital to acquisitions to dividends and buybacks.

Some investors fret that the new company didn't need the money. Wendy's/Arby's is expected to generate more than $100 million of free cash flow, and had $137 million of cash and $116 million in investments at the end of the first quarter. Its next payment on notes, $189 million, is not due until 2011; and $250 million of bank loans aren't due until 2012. So Howard Penney, an analyst at Research Edge, calls the bond deal a "head-scratcher."

But Peltz and May stress the importance of financial flexibility in today's environment. "Our philosophy is that when money is available, you take it, and take the risk out of your balance sheet," says Peltz. Losing a few cents per share in earnings from interest expense is worthwhile, he adds, because the extra cash will enable Wendy's/Arby's to do what it wants when it wants.

Smith seems to be focusing on growth. Arby's, he says, could go from 3,500 stores to 5,000, and even Wendy's, with 6,000 stores in the U.S., could add 1,000 without seeing sales cannibalized. The bond deal could help build new stores and refurbish old ones.

Some of the new stores will carry both Arby's and Wendy's under one roof. Several will be open by year end. The company just struck an agreement with a franchisee to build 135 dual-branded stores in nine countries in the Middle East and North Africa during the next 10 years.

The joint stores let the chains leverage their real estate by sharing a parking lot and seating area. In Ohio, one outlet that housed both Wendy's and a Tim Hortons doughnut shop saw sales volume of more than $3 million annually, compared with the $1.4 million at a typical Wendy's or about $1 million at a Hortons. And average margins were three percentage points higher than the average individual operation's, says May.

A new store can provide a 20% return on invested capital, which would justify the recent bond's hefty yield of 10.5%.

Breakfast offers another growth opportunity. About two years ago, the company began its latest attempt at serving breakfast -- but not to raves. (It had unsuccessfully tried it before.) Last year, new managers under Smith pulled breakfast from most Wendy's, depressing same-store sales comparisons. Now, they are developing a new breakfast menu that will appear in some markets in late 2010 and roll out across the country in 2011.

Smith notes that breakfast accounts for about 20% of store revenue at
Burger King
(BKC) and 25% at McDonald's.

Some investors suspect Trian will direct the company to use some bond proceeds to pay a special dividend or buy back stock. The rumors were inflamed by a recent agreement under which Wendy's/Arby's will pay Trian a quarterly $250,000 fee for Trian's advice on acquisitions, financing, investment banking and initiatives to increase shareholder value. Wendy's/Arby's also will pay Trian a $900,000 fee to assist in selling noncore assets, with a bonus if proceeds exceed expectations. In addition, Wendy's/Arby's invested $75 million with Trian. It plans to take out its money before 2010 and will pay Trian a $5.5 million withdrawal fee. These arrangements make some analysts -- Penney among them -- fear Peltz and May are using Wendy's/Arby's as a cash cow.

But early withdrawal fees are standard in the fund industry, and the advisory fees Wendy's/Arby's pays to Trian will replace fees that the company otherwise would have paid to investment bankers. Trian employs four people in addition to Peltz and May that provide financial services to Wendy's/Arby's. "They are getting their money's worth," says Peltz.

As for a dividend, Peltz says paying a special one would be foolish, but he doesn't rule out a buyback, given his view that the shares are cheap. Some analysts worry the company could become overleveraged, particularly if it does a buyback. After the new bond deal was announced, Standard & Poor's revised the outlook on Wendy's/Arby's single-B-plus-rated debt to negative, while Moody's cut the rating on the Wendy's International unit to single-B2.

The company does have an often-overlooked asset: It owns 700 stores without encumbrances, says May. Since land for new stores costs $750,000 to $1 million, the property might be worth more than $1 a share. Back that out, and Wendy's stock is valued around $2.70 -- less than a quarter-pound burger at one of its New York restaurants.

That makes them look appetizing, regardless of what intentions investors ascribe to May and Peltz.